Irreversible Climate Change Policy

Ryan Avent has been doing some great posting on cap and trade versus carbon taxes. With all information known, the two are theoretically identical. But in the real world they will differ; the question is how much.

One way to think about it is that we are choosing between two kinds of transparency: transparency to regulated companies, and transparency to voters. Politicians like cap and trade because the connection between the plan and higher energy prices will be less obvious to the voters. For that reason, a libertarian should generally prefer a direct tax.

I will discuss the theoretical equivalence of a carbon tax and cap-and-trade below the fold.

In practice, cap-and-trade creates an irresistable opportunity for politicians to use carbon permits as political favors to be handed out to special interests. This in turn means that there will be special interests with a large stake in keeping cap-and-trade policies in place, regardless of what transpires in terms of global temperature.

What is the probability that the United Nations derivation of climate model consensus overstates the problem of man-made global warming? Unless that probability is zero, it seems to me that we should prefer a climate change policy that is reversible to one that it irreversible.

Because I think that the probability that the UN is misleading us is significantly greater than zero, I think that the issue of irreversibility is quite important. Therefore, I think that a carbon tax is far preferable to cap-and-trade. Ten years from now the global warming scare might be completely debunked, and yet we will still be unable to unwind cap-and-trade. As with farm subsidies and many other policies, the problem will be long gone but the solution will be with us in perpetuity.

In theory, cap-and-trade can be equivalent to a tax.

Suppose that your goal is to reduce carbon emissions by 50 percent. You estimate the responsiveness of carbon usage to price, and you raise the tax or taxes on carbon-using activities by the amount that you think will get a response of 50 percent. If you start seeing responses that are different from what you expected, you adjust the tax rate up or down, as necessary. The result is that people substitute away from carbon-intensive production methods and consumption, and government gets revenue from the tax.

With cap-and-trade, you issue a set of permits to be bought by firms that sell carbon-intensive goods or use carbon-intensive production methods. However, you only issue enough permits to allow for 50 percent of today's carbon use. You auction off these permits, and these permits then can be traded between firms as they get a clearer idea of where substitution away from carbon is easy or difficult. This trading takes place in a market, resulting in a market price. The price or carbon permits raises the cost of carbon-intensive consumption and production relative to other forms of consumption and production, causing people to substitute away, exactly as if it were taxed. Assuming that government auctions off the permits, then government gets revenue from the cap-and-trade system, exactly as with a tax.

In theory, you can make cap-and-trade equivalent to a tax. What I worry about is that under cap-and-trade Congress is very unlikely to have a pure auction of permits. Instead, permits will be given to favored industries. The equivalent under a carbon tax would be to set different tax rates for different industries, with favored industries getting anywhere from a partial exemption to a full exemption to a negative carbon tax, or a carbon subsidy. I think that this would be a complex set of tax rates for Congress to manage, both computationally and politically. Therefore, my guess is that using the tax approach there would be less micro-management, and Congress would create fewer clear winners with a stake in perpetuating the policy.

Finally, there is the famous Weitzman paper on "prices vs. quantities." He points out that if the welfare-maximizing government is uncertain about some of the parameters in the system, then setting a price (via a tax) is not equivalent to setting a quantity (via a cap). Students of economics should take time to appreciate the argument, but I think in this case it is less important than the political economy of cap-and-trade. I get the sense that Tyler Cowen, in his comment on this issue, is perhaps indirectly alluding to Weitzman.

Arnold Kling also responds to Megan McArdle. In particular, he favors carbon taxes over cap and trade because carbon taxes are easier to reverse if AGW turns out to be overblown:
What is the probability that the United Nations derivation of climate mod... [Tracked on June 4, 2008 10:11 AM]

I think a carbon tax or cap and trade scheme would be another reason for energy companies and other businesses to move to other countries. To believe that U.S. politicians can effect change upon the earth's climate is pretty far reaching. We will get no climate security from this legislation.

The solution to the international migration problem would be a treaty between countries participating in greenhouse gas reduction efforts which contains an agreement to impose punative tariffs on countries which abstain. I suspect China would sign on to a greenhouse gas reduction effort very quickly if the alternative were a 10% tax on all their exports to the US and the EU.

There is a vast difference between regulating 'prices' versus 'quantities'. A carbon tax raises prices and discourages consumption with a classic economic mechanism. In contrast, a cap sets a fixed upper limit on consumption with affected parties scrambling to outbid each other.

A carbon tax allows the market/society greater ability to adjust and make transitional changes because allowed energy consumption is open-ended and responsive to demand (although potentially expensive). Whereas under a cap, there is no allowance for temporary bulges in demand and no flexibility in consumption during the potentially turbulent transition from carbon based energy to renewables. What if the world is faced with a choice between a speedy but energy intensive transition to renewable power versus a transition made longer by lower energy input? In the end, a quick transition might be more beneficial despite the higher temporary energy demand.

This is a fairly simple example of rational economics (carbon tax) being ignored in favor of big government meddling (cap/trade). And why are we pursuing this? Because the politicians know that if the voters see the true cost of the program, they will demand a reasonable assurance of cost/benefit which in this case can not be given. So we get a huge, inflexible energy tax hidden behind smoke and mirrors.

But hey......it is for the environement. Everyone wants to be green, right?

China has no incentive at all to enter into any kind of greenhouse gas reduction regardless of whether we place an import tariff on their goods. In fact, I believe the current version of the Lieberman-Warner bill has a mechanism to impose just such a tariff, but it will not make any difference.

The general purpose of the tariff is to offset the cost disadvantage imposed on domestic manufacturer's by complying with a cap and trade program, etc. In practical terms, this only makes China's goods cost comparable to domestic products. It does not make them more expensive, because China's other production costs remain lower. At the same time, China is able to service its domestic markets and the remainder of the "non-cap and trade" world completely free of the costs/limitations of the pending cap and trade nonsense.

Now add it up. Chinese exports to the USA and EU suffer some cost inflation, but are still competitive. China's domestic economy continues to hum along completely unhindered by the cost of artificial carbon taxes. Exports to third world and non-cap and trade countries are now even more competitive versus comparable goods from the USA and the EU. No incentive to sign up to be found......

It depends on the tariff rate imposed and on the size of the carbon-limiting market relative to the carbon-unlimited market. The US and the EU together are about half of the world's economy ($36 trillion out of $65 trillion). If you can get Japan, Canada, and Russia to sign on as well, you're up to 2/3 of the world's economy. Would China, India, and Latin America really be able to make up their losses in those markets by selling to each other?

I'm assuming a relatively modest carbon tax and a tariff designed to make not joining the carbon tax regime more expensive than joining (essentially a tax on a country's uncontrolled carbon emissions, collected by garnish their income from trade with participating countries), not just a tariff designed to cover the carbon-cost of imported goods.

Les writes:
Cap and trade or a tax is only a relevant issue if:
a) Climate change is valid science; and
b) It is significantly harmful; and
c) It is due to human activity; and
d) It can be mitigated; and
e) The benefits of mitigation exceed the costs.

Since none of the above have been determined to be valid, there is no issue worth discussing relative to cap and trade or a tax.

But, Les, it doesn't matter what's been proven, it only matters how the IPCC, anti-human environmentalists, and pro-big government politicians (and supporters) believe. This desire for objective, scientific and economic proofs justs shows that you don't belong in our modern society which has given up such irrelevancies. Surely opinion polls and the expert opinions of sociologists, politicians, and astrologists are more accurate for driving the course of mankind (through its governments) than dry scientific and economic reports.

* It's easier to get not-too-bright Republicans to vote against something that is actually in their long-run interest if you can demagogue it by calling it a tax.
* It's easier to get not-too-bright Democrats to vote for something that actually is not in their long-run interest if you can demagogue it by claiming that it's just a restriction on the behavior of corporations and not something that directly impacts people.

If a US company keeps its production in the USA it pays a cap-and-trade premium on every widget it produces. OTOH, if a US company moves its production to a non-signatory country it would only pay a cap-and-trade premium (tariff) on the portion of goods marketed in the USA and EU. The remainder of production would go out to the world unfettered and 'untaxed'. Hence, not only is there no incentive for China and India to sign onto this foolishness, but any US company with a worldwide market now has a significant economic incentive to move production out of the USA and/or EU. This mechanism is already at work in the EU. Steel/iron concerns in germany and france recently warned the EU that if they do not continue to receive special exception from the Kyoto targets their production will being moving overseas.

If a US company keeps its production in the USA it pays a cap-and-trade premium on every widget it produces. OTOH, if a US company moves its production to a non-signatory country it would only pay a cap-and-trade premium (tariff) on the portion of goods marketed in the USA and EU.

Again, I must remind you that US and the EU is 50% of the world market. With a few other likely signatories to a carbon-limiting system, you can easily reach 2/3 of the potential market.

And there's no requirement that the tariff be equal to the carbon tax (I do not favor cap-and-trade) on production within carbon-limiting countries. It can and should be higher, so to remove any incentive for production to relocate. The choice becomes one of producing within the carbon-limiting bloc and paying a carbon tax, or producing in China and paying a substatinally higher tariff on 1/2 - 2/3 of your potential sales (plus the associated problems of moving to China -- language barriers, less market-friendly institutions, currency risk, shipping costs, setup and teardown costs involved with physically relocating, etc).

And that's only if no developing countries break down and sign on to the carbon-limiting regime. If we make the price steep enough, the developing countries will sign on, and we will face neither $10 socks nor jobs shifting overseas.

The effects you fear would be a major concern if Luxembourg and Monaco were considering a carbon-tax-and-tariff pact, but the US, the EU, Russia, Canada, and Japan are too big to shun effectively.

First, there are few substantial impediments to moving production overseas other than artifical barriers such as tariffs and government regulation. Production has been moving overseas from the US/EU (and in some cases back) for years now. The primary driving force for these moves has been cost of production.

Second, expecting solidarity of the signatory market in response to significant inflation in produciton cost is very optimistic IMO. Once the true cost of these measures makes its way through the marketing chain, I believe you will see a number of the signatories finding ways to get around or withdraw from the agreements. Although heavy industry in the EU is currently getting a 'pass' from the Kyoto cutbacks (freebie permits/credits), they have already seen a disaster coming when the free ride ends. For example, the steel conglomerates recently told Germany and France that production will move overseas if they are forced to comply with the same rules as the rest of the economy. They went on to advocate continued special treatment and exemption from the requirements. If you are serious about cap-and-trade, the exemptions must stop, and business will leave.

Third, you advocate an import penalty that is substantially higher than the equivalent cap-and-trade tax. In theory that sounds like a workable idea. In practice, it would work like the 70's import tariffs all over again. Domestic companies would raise their prices to match the prices of comparable imported goods resulting in little competitive disadvantage for importers. The only one getting soaked would be the consumer. Significant amounts of production left the USA for Asia during the 70's despite the tariffs. This suggests that tariffs will not be an impediment to the movement of business toward non-signatory countries.

Fourth, the economic clout of the USA and EU is rapidly failing, and Japan is in both economic and demographic decline. The world's two largest populations are in India and China. The world's fastest growing economies as of late are mostly located in SE Asia. It is a forgone conclusion in financial circles that China will supplant the USA as the planet's economic engine. Throw in eastern europe and latin america for good measure, and the non-signatory portion of the world will be the dominant market going forward.

Fifth, assume the system works as you envision. Production within signatory countries would become limited to that market alone because the cost of cap-and-trade makes exporting to a non-signatory market impossible. As cited above, most of the world's forseeable economic growth will take place in non-signatory countries like India/China/3rd world while the EU/Japan are in decline. Hence, production in the signatory countries would stagnate while growth takes place overseas. I guess you could solve this by artifically subsidizing exports, but that is a whole different discussion.

In the end, the flaws in a cap-and-trade system with penalty tariffs look a lot like the arguments against import tariffs in general. They inhibit trade, inflate domestic prices, and reduce potential economic growth. For those reasons and more, I believe a cap-and-trade system would be an economic disaster from start to finish.

I apologize for the long post....but I love this discussion and you have raised a number of good points. BTW, I agree that a straightforward carbon tax would work much better although it has many of the same economic drawbacks.

You are correct that a carbon tax with a penalty tariff would wind up resembling a protective tariff regime, if there are a significant number of holdout countries. The entire case for my proposal is built on the assumptions that:

1. The carbon limitation regime is something that the signatory countries can live with -- in my head, it's a carbon tax at a relatively low rate, with revenue offset by cut in existing taxes (mostly a reduction in the corporate income tax rate to offset the anti-growth effects of cutting CO2 emissions). If signatory countries start bailing on the treaty, the proposal is doomed.

2. The carbon-limiting bloc has the economic clout and the political will to credibly threaten enough economic harm from the tariff that the tariff will convices the holdout countries to join the carbon-limiting bloc. The goal of the tariff is to provide an incentive for China, India, and Latin America to join in on the carbon tax, not to punish them for refusing to do so.

Will returns really be that much greater in the rest of the world, and how many firms can relocate to take advantage of them before the return difference is competed away?

I'm envisioning a carbon tax that would raise the cost of energy by 5-10%, with the revenue used to lower corporate income tax rates in order to mitigate the negative effects of the tax. I don't think the effect on productivity will be that huge. If you're thinking of the level of carbon reduction Obama is proposing (a cap and trade regime designed to roll back per capita carbon emission to 16th century levels), that may be where our disconnect is coming from.

You have to look at the options on the table. A 5-10% carbon tax with corresponding tax reducitons would be heresy to the global warming folks.

None of the proposals being floated is revenue nuetral, and most would cost way more than 10%. The front runner options up for vote in the Senate are cap-and-trade with trillions of dollars in auctioned permit fees (taxes) and no corresponding tax reduction.

While your idea is something that might be effective, it isn't even close to what is being propsoed.

If we want to limit ourselves to proposals that are currently on the table, then I'm solidly in the "do nothing" camp. The current mainstream estimates of warming in the coming century would do a lot less harm than taxing our economy back into the middle ages.

The downside to a carbon tax is very small if it is balanced with a reduction in income and other taxes. The same can be said for the proceeds from an auction of permits. I know that getting there difficult, that there are many public choice problems between here and there, but it's a reasonable, clear goal. You guys are just making up rationalizations for doing nothing about likely climate change. Sophisticated rationalizations, no doubt, but rationalizations. Don't be surprised if nobody takes you seriously.

Quibbles as to the details of water vapor models, or short-term temperature trends, or effects of particulates are just that - quibbles. The science is unambiguous on the overall trend and its long term effect. Anybody who has spent five minutes contemplating the Mauna Loa CO2 time series and who has any knowledge of the physics of greenhouse gases knows that we are screwing with something very big, and doing it in a very big way. http://www.esrl.noaa.gov/gmd/ccgg/trends/co2_data_mlo.html The concentration of CO2 in the atmosphere has increased by nearly 25% in the last 50 years, and there's no end in sight. If you don't think we've got anything to do with this trend, you are in denial. Screwing with the atmosphere is not wise, and if we can avoid doing it at anything like reasonable cost we should do so. Swapping our current tax system for a carbon tax or cap-and-trade auction offers just such a reasonable cost path.

Pardon me if I suspect that you guys just don't think that environmental protection is a legitimate government function. If that is the way you feel, the burden of proof is on you to show that the textbook account of externalities and tragedy of the commons doesn't apply to the emission of CO2. Obviously, there are problems with government environmental regulation, and all government action should be viewed skeptically. But accusing people who take the opposite point of view of being power hungry big-government socialists who don't understand the science is simply inaccurate. http://www.esrl.noaa.gov/gmd/ccgg/trends/co2_data_mlo.html

I was making nmbers up, but 2-3 X is about the current state of the world. growth rates are much higher in RoW and returns should be similar. Risk aversion, branding keeps people in our market, but it;s just a matter of time and availiblity of exuses before they start looking else where.

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